Macro Strategy: Asia FX & rates still face Fed tightening headwinds

FX: Global monetary outlook is siding with the USD
The Fed, over the past year, has been unwinding its balance sheet to 20% of GDP from 23%. This compares favourably with the sizable balance sheets at the European Central Bank (40%) and the Bank of Japan (100%). Given the concerns over the side-effects of their ultra-loose policies, ECB and BOJ will, compared to the Fed, have less flexibility to respond effectively to any global shocks ahead. Hence, the risk remains for the USD Index (DXY) to appreciate above 100 next year, on further depreciation in the euro and Japanese yen past 1.10 and 115 respectively.

The divergence story will also drive the Chinese yuan weaker past the 7 level. We see three cuts in the reserve requirement ratio by a total 150-300 bps in 2019. Trade tensions with the US have already led China’s growth to the lows of the global financial crisis. Looking ahead, the US import tariff rate on USD200bn of Chinese goods is set to rise to 25% from 10% from January 1, 2019. US President Trump has also reserved the right to impose tariffs on the remainder USD267bn of its goods. Unlike the GFC, China has today, a weaker current account position and accumulated large debts in the housing, corporate and local government sectors. It will be more challenging to cushion growth with domestic demand while maintaining financial stability this time around.

The greenback will also be widening its positive interest rate differentials with the surplus- and export-led Asian currencies. Despite their half-full outlook, the South Korean won and the Singapore dollar have found it increasingly hard to ignore the faster-than-expected growth moderation in the world’s largest economies (Eurozone, China and Japan) from trade tensions. Asia’s twin-deficit currencies (the Indian rupee, the Indonesian rupiah and the Philippine peso) will also need to be mindful of rising US real interest rates. After having turned positive this year, real Fed Funds Rate is estimated to be some 100 bps above the core PCE deflator in 2019.

Rates: Asia rates still facing Fed headwinds
Volatility in the markets is not going to deter the Fedfrom hiking several more time in 2019. As USD rates edge even higher, Asia policy rates will be dragged higher again, but the nuances matter. Through the Fed normalisation over the past two years, the reaction for Asia rates is different in 2017 and 2018. In 2017, policy makers were able to keep rates low due to synchronised global growth and a risk-on environment. This kept funds flowing into the region even as the Fed hiked three times that year. That changed in 2018. When global growth diverges, USD strength became apparent, prompting a much more cautious tone for investors. Twin-deficit Asia economies (Indonesia, India and the Philippines) hiked rates to ensure financial market stability when stress started appearing in the 3M rates and longer-dated yields.

2019 is likely to be a blend of 2017 and 2018. Global growth divergences should narrow as US growth moderates to 2.5%. Moreover, Asia rates in the higher-yielding economies have already adjusted significantly (real rates are high in Indonesia and India) over the past few quarters as complacency gets worked out of the system. This sets the stage for a more modest hike cycle for the twin deficit economies in 2019 even as we see the Fed hiking another four times. In fact, we argue that there is still some risk and/or liquidity premium imbedded in the interest rates of twin deficit economies. As such, policy rate hikes need not necessarily translate into a 100% passthrough unto 3M interbank or FX-implied rates. Similarly, even if yields rise in these economies, local currency govvies (with much higher absolute yields) may be attractive from a total return perspective.

Malaysia, Thailand, Korea and Taiwan are lagging peers in the monetary policy cycle. Korea and Taiwan have well-supported external balances and are likely to face headwinds from trade. There is little scope for policy rates (we have a token hike for Korea by the end of this year) or govvie yields to rise even if USD rates get meaningfully higher in 2019. For Malaysia, we expect yields to be broadly steady with the central bank facing inertia in either direction. Oil prices remain a key risk and we suspect that the curve would steepen if prices fell much lower. Meanwhile, the THB curve is already pricing in a modest rate hike cycle as the central bank turns modestly more hawkish.

Lastly, policy settings are going to stay accommodative in China through 2019. While we do not think conditions warrant an adjustment in the 1Y lending rate, we have assumed that liquidity would be kept ample (more RRR cuts could be in the offing) to cushion downside from the ongoing trade war with the US. That said, we think that longer-term govvie yields may be rangebound (drifting lower before heading back up). Yields are low in absolute and relative (compared to the US) terms. It is unclear that lower CNY rates can be sustained in when China’s current account dynamics has deteriorated and we still expect USD rates to climb.